Professor Paul Zarowin - NYU Stern School of Business

Professor Paul Zarowin - NYU Stern School of Business

Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes

Pensions and OPEB=s

 defined benefit vs defined contribution plans

 pension assets: FMV

 pension liabilities: VBO, ABO, PBO

 comparison to other liabilities (effective interest method)

 importance of assumptions: r%, g%, actuarial, E(ROA)%

 components of pension expense:

 permanent components: + service, + interest, - E(ROA)

 smoothing of transitory gains, losses: U(ROA), UNG/L, UPSC, Transition

 recognized (on B/S) vs unrecognized balances (Atrue@ vs reported@ position)

Acorrecting@ the financial statements

 footnote disclosure: expense components, funded status reconciliation, assumptions

 worksheet

 OPEB=s

Pensions and OPEB=s

In a pension plan, the employer puts assets into a (pension) fund; these assets are invested and the funds are used to pay income to the retirees. Thus, assets flow from the employer into the fund (funding the plan), and from the fund to the retirees (paying the pension benefits). There are two types of pension plans, defined benefit and defined contribution plans. For a defined contribution plan, the employer must put a certain amount into the employees= pension fund each period (the defined contribution). After this contribution, the employer=s obligation is finished. Employees bears all the risk of how much or little income they will have during retirement, depending on how well the funds were invested. The employer=s accounting for a defined contribution is a simple Apay as you go@ (de facto cash basis):

DR CR

pension expense

Cash

The entry is made for the amount of the defined contribution. The employer may put more or less funding into the plan in a given period. If more, there is an asset Aprepaid pension cost@; if less, there is a liability Aaccrued pension expense@. Otherwise, no asset or liability is recognized.

For a defined benefit plan, the employer guarantees the employee a certain pension income during retirement (the defined benefit). Since there is an obligation of the employer, the accounting for a defined benefit plan is much more involved than the accounting for a defined contribution plan. This module focuses on the employer=s accounting for a defined benefit plan.

The accounts for a defined benefit plan are: (1) pension expense (I/S), (2) cash (which the employer uses to fund the plan), (3) prepaid/accrued pension cost (B/S), (4) pension liability (fn), (5) pension assets (fn), (6) Unrecognized Net Gain/Loss (UNGL, fn), (7) Unrecognized Prior Service Cost (UPSC, fn), and (8) unrecognized transition asset or liability (UTA/L, fn).

Additionally, the firm must make 3 key assumptions about: (1) expected ROA% - the expected rate of return on pension assets, (2) r% - interest rate used to discount the future payments, to calculate the pension liability, and (3) g% - expected salary growth rate, to determine the future payments to retirees.

For understandng pension journal entries, it is useful to show the eight accounts in a horizontal grid. Firms actually prepare such a report, a pension worksheet for internal accounting purposes, which simplifies the accounting process. As we=ll see, the reconciliation schedule in the pension footnote (see RCJ=s GE example on page 708-709 and 711-714) shows the same information vertically.

Pension exp. Cash pp=d/acc=d cost ▌Pens. Assets Pens. Liab.UNGL UPSCTrans.Ass/Liab

I have deliberately put the pension expense, cash, and prepaid/accrued pension cost, on the left side of the hash mark, because these are the Aon financial statement@ accounts. The other 5 accounts are not on the financial statements, and must be found in the footnotes. In principle, these 5 accounts could have been on the B/S, but firms lobbied against this, fearing that a large pension liability on the B/S would make them appear too risky. As we will see, the prepaid /accrued pension cost account is the net of the 5 accounts; since the DR and CR balances of these 5 accounts cancel each other out, the balance in the prepaid/accrued account tends to be small.

The simplest (and theoretically correct) accounting for a defined benefit pension plan would have pension assets and pension liabilities on the B/S, and the net change in these accounts as a CR or DR on the I/S. Assets would be measured at FMV and marked-to-market each year (in fact they are), as they are primarily securities with known FMV=s. Liabilities are the NPV of expected future cash payments to retirees, discounted at the assumed r%. Thus, the pension liability is just like any other non-current liability, except 1. the future cash flows are not known with certainty, but must be estimated based on various actuarial assumptions, and 2. A discount rate is not market-determined but must be assumed, because the liability is not traded. For example, assume that the assets (security portfolio) went up a lot (good stock market year), and the liability also grew, but not as much. The je would be: DR CR

pension assets

Pension liability

Net pension gain (or revenue)

Alternatively, assume that the security portfolio fell in value (bad stock market year), and the liability grew. The je would be: DR CR

Net pension loss (or expense)

Pension assets

Pension liability

In this simple accounting, all we would need to do is measure the assets and liability at the end of the year, and record the changes. Unfortunately, pension accounting is not so simple, because:

1. firms wanted to keep the assets and liabilities off the B/S (relegated to the pension footnote), in effect showing only the net; this keeps a large liability off the B/S - the net is the Aprepaid-accrued pension cost@ account in the grid. If only the net asset or liability were shown on the B/S, pension accounting would still be simple; but, 2. Recording the net change as a gain or loss can make net income very volatile, which firms dislike because it makes them appear risky (e.g., the stock market has large swings, and big changes in the liability are induced by occasional changes in the plan contract itself or in its assumptions.)

Thus, actual pension accounting has numerous devices that 1. Smooth pension expense (net income), and 2. Make the net asset or liability on the B/S different from the true net asset or liability. The difference between the true net asset or liability and the prepaid/accrued pension cost (the on B/S asset or liability) is the sum of the UNGL, UPSC, and Trans.Ass/Liab in the grid. This difference is shown as a reconciliation schedule in the pension footnote. In addition to the reconciliation schedule, the pension footnote also shows pension expense and its components, and the assumptions mentioned above.

Pension expense is the employer=s periodic expense on the I/S due to the pension plan and is the sum of the following components:

(1) service cost - This is the present value of the benefits (liability) that are earned this period

(2) interest cost - This is the interest on the pension liability. It is computed as: r% x beginning of period liability value. This is called accretion of the liability as it gets closer to ultimate payment. It is analogous to interest expense on a zero coupon bond. The journal entry to recognize the service and interest cost components of pension expense is:

DR CR

Pension expense

Pension liability

(3) return on assets - There are 2 important points here. First, positive ROA is a negative hit to (reduction in) pension expense. The intuition is that the greater the growth in the assets from a high return, the less that the firm has to fund the pension plan to pay the future benefits, because the assets do it themselves. Second, the amount of the entry to pension expense is the expected return on assets (not the actual return), which equals the expected ROA% x the beginning of period balance of pension assets. Since pension assets increase or decrease by the actual return, there may be a difference in the amount of the pension expense versus the amount of the change in the pension assets. This difference is charged to the UNGL account so that the entry balances.

For example, assume that the firm has an expected ROA% of 9.5%, and that beginning of period pension assets is 1,000,000. If the actual ROA% is 12%, the journal entry is:

DR CR

Pension assets 120,000

Pension expense 95,000

(3.1) Unrecognized net gain 25,000

If the actual ROA% is 5%, the journal entry is: DR CR

Pension assets 50,000

(3.2) Unrecognized net loss 45,000

Pension expense 95,000

If the actual ROA% is -4%, the journal entry is: DR CR

unrecognized net loss 135,000 (3.3) pension assets 40,000

Pension expense 95,000

If the actual ROA% is 9.5% (equal to the expected ROA%) the entry is:

(3.4) DR CR

pension assets 95,000

Pension expense 95,000

Note that the CR to pension expense in each case is 95,000, regardless of the actual ROA%. Thus, the expected ROA% is an important assumption in the determination of pension expense.

The entry to pension expense is based on the expected ROA%, because actual ROA% is extremely volatile (pension assets are usually invested in stocks). Basing pension expense on the actual ROA% would induce extra volatility into pension expense, and thereby into net income. Firms do not like this, because it makes them appear to be riskier. This example highlights the smoothing of pension expense that is a key feature of pension accounting. We will see more examples of smoothing, below. DR or CR entries to UNGL because expected and actual ROA% differ are called asset gains and losses.

As long as the expected ROA% accurately reflects the long run average ROA%, the DR=s and CR=s to the UNGL will cancel out and the net balance will stay small. In this case, there is no need to amortize UNGL. If the UNGL gets too big, it must be amortized. An example of this might occur if management opportunistically sets the expected ROA% too high, in order to get a large CR (negative) entry to pension expense each period, in order to enhance net income. This is shown in entry 3.2, above. In this case, a DR will build up in the UNGL account, and it will have to be amortized. The entry is:

DR CR

pension expense

UNGL

Note that the amortization is a component of (increases) pension expense, so the too high expected ROA% ultimately backfires.

The UNGL must be amortized at the end of a year if its beginning of year balance reaches a DR or CR balance outside a Acorridor@, defined as the 10% of the greater of beginning of year pension assets or pension liabilities. Note that firms must amortize down to the corridor, not to zero. This is called corridor amortization. Note also that the need to amortize changes each year, because both the 10% corridor changes and the amount of the UNGL balance changes. Thus, amortization in one year does not tell you if there will be amortization the next year. If the UNGL is inside the corridor, firms may elect to amortize it, but they do not have to. The amortization is generally done SL over the expected remaining service life (average # of years until retirement) of the employees. Amortization of the UNGL over many years (rather than immediately) is an example of smoothing pension expense.

Pension assets are the assets in the pension fund that will be used to pay the employees= retirement income, and are measured at FMV. The firm=s funding the plan and the assets earning a (positive) return increases pension assets; using to assets to pay the retirees (honoring the pension liability) decreases pension assets. The entry for funding the plan is:

DR CR

Pension assets

Cash

The entry for paying the retirees is: DR CR

Pension liability

Pension assets

Note that this entry reduces both pension assets and pension liability. See the entries for return on assets, above.

Pension liability is the employer=s liability to pay the defined benefit; i.e., it is the present discounted value of the cash expected to be paid to the retirees. In this way, it is like any other non-current liability. The main difference is that with a monetary liability (bond or note), both the future cash outflows and the discount rate are known. For a lease liability, the future cash outflow are known, and a discount rate must be applied (to calculate the PV). For a pension liability, it can only be estimated, based on the terms of the pension contract and actuarial estimates about how long people will live. Pension contracts stipulate the monthly income that a retiree will earn (usually based on years of service and final salary).

You can think of an employee=s pension as an annuity for a contracted amount for an actuarially expected duration. To compute the firm=s pension liability to the employees, there are 2 steps: first PV the annuity as of the workers= date of retirement, using the actuarially determined retirement life; second, PV this value back to the present, using the average remaining service life of the employees. The assumed interest rate (r%) is used to compute the PV of the liability.

Note that a higher assumed interest rate will lower the liability, but this effect will be offset somewhat by the effect of the higher interest rate in the calculation of the interest component of pension expense (see above). In general, the lowering effect will dominate. Thus, along with the assumed expected ROA%, the assumed interest rate is another way that firms can affect their pension expense and pension liabilities. RCJ (pg. 697) show the range of rates that firms use.

There are 3 different definitions of the pension liability discussed in the text. The most important one is the projected benefit obligation (PBO), which computes the liability based on expected salaries when the workers retire, which is more realistic (for a going concern) than using current salaries. This is where the expected salary growth rate (g%) comes in. The PBO is the liability definition used in the interest expense component of pension expense, above. An alternative definition of the pension liability is the accumulated benefit obligation (ABO). It is the same as the PBO, but without the effect of salary growth. Additionally, the vested benefit obligation (VBO) is the vested portion of the ABO. Thus, the PBO must be greater than the ABO (because g% > 0) and the ABO > VBO (because all employees aren=t vested). If the pension assets are greater (less) than the PBO, the plan is overfunded (underfunded).

Thus, the factors that affect the pension liability are: the assumed interest rate, the expected duration of retirement, the periodic payment, and the time until retirement. If the actuarially determined duration changes (for example, people live longer), the PBO increases. The entry is:

DR CR

UNGL

PBO

This is called a liability loss or actuarial loss (a liability gain or actuarial gain is the opposite). Note that the DR is to the same account, UNGL, as the asset gains/losses, and either reduces or increase the net balance in the account, thereby affecting the need for corridor amortization. The DR to UNGL (rather than recording the loss by a DR to pension expense) is another example of smoothing pension expense. Thus, occasional liability losses affect pension expense gradually over time via amortization of UNGL (if it exceeds the corridor).

Unrecognized Prior Service Cost (UPSC) The PBO can also be changed by a contractual change in the defined benefit. For example, assume that the pension plan is improved (sweetened) thereby increasing the firm=s PBO. The entry is: DR CR

UPSC

PBO

UPSC has a DR (asset) balance, because it represents goodwill between the firm and employees. The DR to the UPSC, (rather than recording the loss by a DR to pension expense) is another example of smoothing pension expense. Thus, occasional contractual changes affect pension expense gradually over time via amortization of UPSC. Unlike the UNGL however, the balance in the UPSC account must be amortized. The amortization is also generally done SL over the expected remaining service life.

Unrecognized Transition Asset or Obligation (UTA/L) At the date of a firm=s adoption of the current pension accounting as described above (SFAS #87, 1985) firms with defined benefit plans might have had a net underfunded (PBO < Pension Assets) or a net overfunded (Pension Assets > PBO) pension plan. This difference between PBO and Assets at the date of adoption is called transition obligation (asset). For most firms the net amount was small, because most plans are adequately funded, both because of ERISA=s requirements and because funding is tax deductible.

Any transition balance must be amortized into pension expense over the employees= average remaining service life. This done by the je (shown for a transition asset, just reverse for a transition liability):

DR CR

prepaid/accrued pension cost

pension expense

Note that the amortization of the unrecognized asset or liability effectively recognizes the asset or liability by putting it on the B/S, in the prepaid/accrued pension cost account. Amortization of a unrecognized transition asset (liability) increases the on B/S asset (liability) and lowers (raises) pension expense. Amortizing this asset/liability is another example of smoothing, rather than affecting pension expense in one shot. The balance in the grid (reconciliation schedule) is the remaining unrecognized balance.